As the economy has worsened over the last year, many homeowners have struggled to hang onto their homes. Some have been able to renegotiate their loan terms. Others haven't been as fortunate, losing their residences to foreclosure.

But at least these homeowners, and former homeowners, no longer face what once was an unexpected, and often quite costly, tax bill associated with the refinancing or loss of their residences.

Thanks to the Mortgage Debt Forgiveness Act of 2007, the writing off, or forgiveness, of some of a mortgage loan is no longer a taxable event. That didn't used to be the case.

Under prior law, when a home's value decreased and the lender and borrower negotiated a reduction in loan principal, the difference between the original and new debt was taxable income. A homeowner also could face similar tax liability when the lender completed a foreclosure and sold the home for less than the outstanding mortgage.

Officially, it is known as cancellation of debt, or COD income. It also is sometimes called discharge of indebtedness income or debt forgiveness. Regardless of the name, it produced a homeowner tax bill, generally calculated at ordinary rates ranging from 10 percent to 35 percent, depending upon the homeowner's income.

What the previous tax law essentially did was treat the foreclosure as a sale by the debtor, the owner of the property, with the proceeds being paid to the lender. Now, however, some homeowners who renegotiate their mortgages by Dec. 31, 2012, will not face any taxes on debt forgiven in the process.

Lawmakers hope that the original law and the subsequent extension of its tax relief through 2012 will increase the incentive for borrowers and lenders to work together to refinance loans and keep people in their homes.

Still some restrictions

Although mortgage-related COD income is off the tax books for the next few years, some homeowners facing financial difficulty could still end up facing an IRS bill.

There is a $2 million limit on the amount of COD income that escapes taxation. The limit is $1 million for married couples who file separate returns.

The loan must be to buy, build or substantially improve a principal residence, i.e., the property in which the homeowner lives. Debt forgiven on vacation or investment properties or a second home will still count as income.

And homeowners who took advantage of the run-up in real estate prices to refinance their mortgages can only use the cancellation of debt law in connection with higher mortgage debt that was used to improve the home. Such cash-out refinancings where the homeowner took out money to pay for purchases, such as a vehicle or to pay off credit card debt, don't qualify for the exclusion if they are forgiven.

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Mark Luscombe, principal federal tax analyst with CCH, a tax software and publishing company in Riverwoods, Ill., says that taxpayers who take advantage of the law will have to reduce their basis in their homes by the amount excluded. For example, someone who paid $300,000 for a house and had $20,000 in mortgage debt forgiven will figure that their basis in their home is now $280,000. If they later sell their home for $350,000, their gain will be $70,000 rather than $50,000.

The good news here is that other home-related tax law offers some cover. "Since single people can exclude as much as $250,000 in gain on the sale of a home, and joint filers as much as $500,000, in many cases there is no tax due anyway," says Luscombe. "Even if there is, most people would be willing to trade a capital gains tax in the future for tax relief at ordinary income rates today."

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